As hard as it is for parents to find extra cash to put away for college, deciding where to put it offers its own challenge. To get you started, here is a quick overview of the four main options you have for setting up an account. Your financial advisor or accountant can help you determine which is best suited for your particular financial situation.
529 College Savings Plans
These are tax-advantaged accounts offered by states. Anyone can use them—there are no income or annual savings limits and many states plus the District of Columbia offer tax deductions for your contributions, according to Mark Kantrowitz, senior vice president Edvisors Network and publisher of FinAid, a college savings website.
But, he also warns that there are two types of plans: advisor-sold and direct-sold. The direct-sold plans tend to have lower fees and allow you to invest directly with the state of your choice. The advisor-sold plan can offer higher investment returns, but carry higher fees. Kantrowitz advises parents to look for plans with fees that are under 1 percent.
- Contributions are made on an after-tax basis, but taxes on any investment gains are deferred or tax-free if the beneficiary’s withdrawals are used to pay qualified college expenses.
- You have the option to invest in any state’s plan, not just your home state’s.
- The donor has complete control of the account. You are able to change beneficiaries—or reclaim the money for yourself—if the original beneficiary doesn’t use the money.
Coverdell Education Savings Accounts (ESA)
Though versatile, these accounts carry income and annual savings limits. Specifically, contributions to a Coverdell ESA are limited to $2,000 a year. Once the account is established, the balance may only be distributed to the named child, but that beneficiary has until they turn 30 to withdraw the money free of taxes and penalties.
- Contributions are made on an after-tax basis, and taxes are deferred on any investment gains. The beneficiary’s withdrawals to pay qualified expenses are tax free.
- Withdrawals may be made for elementary and secondary school expenses as well as for college.
- Qualified expenses are broadly defined and may also include some trade school expenses.
Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA)
In most states, minors cannot legally contract on their own behalf. This precludes them from owning assets, including college savings accounts. However, a simple custodial account structure—UGMA or UTMA depending on state statutes—may be used for holding assets until the child reaches the age of majority (18 or 21, depending on the state). At that point, all the assets held in custodial accounts transfer to the control of named child. That child is under no obligation to use the money for its intended purpose. This means that while you may have been saving for an ivy league-caliber education, your child is free to spend the money on whatever they choose. While a simple way to save, this is a major drawback.
Saving in Your Own Name
Another option is to simply save money in your own name and earmark it for college. This provides you with complete control over how the money is spent, how much of it you spend on each child, and if for some reason you need those funds due to an interruption in employment or for a family medical expenses for instance, you have the flexibility to access your funds at any time.
Regardless of how you decide to save, Kantrowitz encourages you to make the effort and to save for college early and often: “Every dollar you save is a dollar less you or your child will have to borrow. And every dollar you borrow will cost roughly two dollars by the time you repay the debt.”